To IRA or not To IRA? That is the question (or at least one of the questions)
The most important life objective for most people is saving and investing for retirement. Individual Retirement Accounts (IRAs) are an important consideration in meeting this objective. Today we review the types of IRAs available and the differences in how much is accumulated for retirement in the various types of IRAs. To skip right to the conclusion, if you have money to make investments that will not be needed until retirement, have earned income and expect your tax rate in retirement to be the same or lower than your current tax rate, you should be contributing to an IRA even if it is non-deductible.
There are two basic types of IRAs:
- Traditional IRAs
- Roth IRAs
The maximum contribution to each of these is $6,000 per year if you are below age 50 or $7,000 per year if you are age 50 and above. Note that you or your spouse must have earned income (e.g. salary or self-employment income) to make any IRA contributions. If your earned income is less than $6,000 your contribution is limited to your earned income.
There are two potential advantages to traditional IRAs:
- Your initial contribution may be deductible and save you taxes currently.
- Investment earnings accumulate on a tax deferred basis. Rather than being taxed each year, taxation is deferred until you take distributions from the IRA. This allows you to accumulate more wealth over time, reinvesting funds that would otherwise be paid in taxes currently.
We will explore how much this impacts the amount of wealth you will accumulate at retirement a bit later.
Traditional IRAs may be deductible or non-deductible depending on whether you have a retirement plan available through your employer and your level of income. If neither you nor your spouse are covered by a retirement plan at work, then traditional IRA contributions are fully deductible. If either of you are covered by a retirement plan at work, then the IRA is fully deductible if your adjusted gross income is below certain levels depending on your tax filing status:
- Single $68,000
- Married filing jointly $109,000
- Married filing separately – not fully deductible in any case
If your income is above these levels an IRA contribution is partially deductible if your income is below:
- Single $78,000
- Married filing jointly $129,000
- Married filing separately $10,000
If your income is above these levels traditional IRA contributions are not deductible. Note, however, that as long as you have earned income of at least $6,000 you can always make a contribution to a traditional IRA. The only limitation is on deductibility.
Roth IRAs also have two potential advantages, even though contributions are not tax deductible:
- Investment earnings accumulate tax free in the Roth IRA.
- There is no tax on Roth IRA distributions provided certain requirements are met.
Regardless of whether you are covered by a retirement plan you may make a full contribution to a Roth IRA if your income is below:
- Single $129,000
- Married filing jointly $204,000
- Married filing separately – no full contribution in any case
If your income is above these levels but below the following levels, you can make a partial Roth IRA contribution:
- Single $144,000
- Married filing jointly $214,000
- Married filing separately $10,000
If your income is above these levels, you may not make a Roth IRA contribution.
So, depending on your circumstances you may have several possible investment alternatives among the following:
- Not invest in an IRA but invest in a regular taxable investment account
- Invest in a non-deductible traditional IRA
- Invest in a deductible traditional IRA
- Invest in a Roth IRA
For comparison purposes we will assume you have $6,000 per year total to invest and that your investment return will average 5%. We will also use an investment horizon of 20 years until retirement. We assume you are currently in a moderate marginal tax bracket or 22% and will be in a 12% bracket in retirement. This assumes someone who is married filing jointly with income between about $80,000 and $180,000 currently and less than $80,000 during retirement (we will also show how results will change based on other tax rate assumptions). Note that while the numbers would change if your retirement horizon is less than or more than 30 years, the conclusions of the analysis would not change.
In the case of a regular account, you would invest the full $6,000 in a taxable investment account. Your wealth would accumulate after taxes (you would be paying tax on your 5% income each year if it is interest, dividends and realized capital gains). Your ending wealth at the end of your investment horizon in this case would be:
|Circumstances||Cumulative Investment||Ending Wealth|
|$6,000 invested each year, 20 years to retirement, current tax bracket 22%||$120.000 (20 years at $6,000 per year)||$176,826 (If all investment earnings are taxed each year)|
Note that the above calculations assume the full amount of investment income is taxed currently as interest, dividends and realized gains.. If you invested in an index fund where some of the income is taxed each year and the rest is taxed when sold you would accumulate more. Let’s assume that 2.5% is taxed each year (interest, dividends, some realized gains) and the balance of 2.5% (unrealized gains) is taxed when sold during retirement but at a favorable long term-gain rate of 15%. We adjust for the capital gains tax effect in year 20 although the tax on gains are paid as the wealth is used (you do not sell the entire fund balance at your retirement date). Your ending wealth after all taxes would be:
|Circumstances||Cumulative Investment||Ending Wealth Adjusted for Taxes During Retirement|
|$6,000 invested each year in a taxable investment account, 20 years to retirement, current tax bracket 22%||$120.000 (20 years at $6,000 per year)||$181,579 (If half of investment earnings are taxed each year and the balance is deferred until retirement)|
Non-Deductible IRA Account
In the case of a non-deductible IRA account, you would also invest the full $6,000 per year. Your wealth would accumulate tax deferred until withdrawn. For comparative purposes simplicity we will reduce the taxes at year 20 as above, although they would be spread out over your retirement period. Note that your cumulative contributions are withdrawn tax free in the case of a non-deductible IRA Your ending wealth at the end of your investment horizon would be:
|Circumstances||Cumulative Investment||Ending Wealth Pre Tax||Ending Wealth Adjusted for Taxes During Retirement|
|$6,000 invested each year in a non-deductible IRA, 20 years to retirement, current tax bracket 22%||$120.000 (20 years at $6,000 per year)||$198,396||$188,988|
Ending wealth after taxes is higher for the non-deductible IRA than for a taxable investment account. This will be true whenever your future expected tax rate is lower than your current rate. Let’s assume your future tax rate upon withdrawals is the same as today rather than lower. How would your ending wealth change if your tax rate was still 22% during retirement? Your ending wealth would be a little less after taxes but still at $181,149. This is higher than the regular investment account assuming taxes are paid fully annually but about the same as the regular investment account assuming a deferral of capital gains which are taxed later at a favorable rate. The non-deductible IRA is the better choice for your investment dollars than a taxable account if you are currently in a high tax bracket and expect a lower tax rate in retirement. A taxable account generating deferred long-term gains would be preferable if you expect a higher tax rate during retirement.
If you invest $6,000 each in a deductible IRA while you are in a 22% tax bracket you would save $1,320 in taxes so your after-tax investment is only $4,680 per year. In order to compare your wealth accumulation to the other choices, we will assume that the tax savings are invested in a regular taxable account (making your total out of pocket investment $6,000 per year or $120,000 over 20 years as in the prior examples). Before considering taxes your ending wealth would be:
|Circumstances||Ending Wealth Pre-Tax – IRA||Ending Wealth Regular Investment Account (taxes paid each year)||Total Ending Wealth Pre-Tax on IRA|
|$6,000 invested each year in a deductible IRA, $1,320 of tax savings invested in a taxable investment account, 20 years to retirement, current tax bracket 22%||$198,396||$38.902||$237,298|
After taxes these would equate to:
|Circumstances||Ending Wealth After-Tax – IRA||Ending Wealth Regular Investment Account (taxed paid each year)||Total Ending Wealth After-Tax|
|20 years$6,000 invested each year in a deductible IRA, $1,320 of tax savings invested in a taxable investment account, 20 years to retirement, current tax bracket 22%||$174,588||$38.902||$213,490|
The deductible IRA accumulates more wealth than either a non-deductible IRA or a taxable investment account. This is true even if you end up in a 22% tax bracket in retirement. In that case ending wealth after tax would be $193,651. The deductible IRA is almost always the preferred choice if it is available. The only way for it to not beat a taxable retirement account is if you tax rate is higher during retirement than it is when contributions are made.
For the Roth IRA we once again assume $6,000 of contributions each year for a cumulative total of $120,000. Your wealth accumulation would be:
|Circumstances||Ending Wealth Pre-Tax||Ending Wealth Adjusted for Taxes During Retirement|
|$6,000 invested each year in a Roth IRA, 20 years to retirement, current tax bracket 22%||$198,396||$198,396|
Note that your pre-tax and after-tax wealth are the same as Roth Distributions are tax free assuming you have had the Roth account at least 5 years and the distribution is after age 59 ½ or due to disability. The Roth IRA is always better than the regular investment account and the non-deductible IRA. The deductible IRA is still the better choice when taxes are lower in retirement, and you invest the annual tax savings resulting from the deductible IRA.
The Bottom Line
To summarize and answer the question to IRA or not to IRA, the answer is almost always yes to making an IRA contribution for investments where the money is not needed until retirement. Except in circumstances where you are in a lower tax bracket today than at retirement, you will accumulate more wealth in an IRA. So, if you have earned income and expect to be in the same or lower tax bracket during retirement you should contribute as much as allowable to an IRA with your first choice being a deductible IRA. If not possible, the next best choice is a Roth IRA. If you cannot make either, then a non-deductible IRA is likely your next best choice. In this case work with your financial planner or tax advisor to determine your current tax rate and expected rate during retirement. If you expect to be in a higher tax bracket during retirement that you are today, then a taxable investment account with significant deferred income may be better than a non-deductible IRA.
 There is another option which is to make a traditional IRA contribution and then covert or partially convert the traditional IRA to a Roth IRA. We will cover this in a later post.